• Sep 2010
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M&A: capital structure

The many headwinds faced during 2009 – the low availability of credit, poor earnings visibility and a general “wait and see” attitude – have not entirely abated but are definitely not blowing as strongly as they did before. But perhaps the more important trend has been a new focus on using M&A to reorientate and retool businesses to face a changed business environment.

The character of M&A has changed substantially. Until 2008, M&A was being driven mainly by acquirers seeking to expand. But from 2008, M&A was driven more by sellers, often out of a desire to raise capital or secure their capital structure. In short, M&A went very quickly from being primarily aggressive to being primarily defensive.
One of the critical features of 2009 that may continue, perhaps to a lesser extent, will be the international shortage of credit. This has forced companies to reassess their priorities, which will be a continuing feature of M&A in the near future. For example, the second largest deal completed last year and the largest single deal of the year was Anglo American's sale of its remaining stake in AngloGold Ashanti to US hedge fund Paulson. Anglo American has since its founding been associated with the gold industry, but the need for capital to expand elsewhere encouraged the group to dispose of its remaining stake in the company.

Capital structure is at the root of M&A. It's the underlying motivation that in a sense always existed but which is now, after the economic downturn, so more apparent. The unique character of the recent economic downturn was that capital went from being plentiful to being in extremely short supply, which has focused minds on the issue.

The critical insight is that managing your capital structure is the key to resetting a company's performance matrix. This is why so much of the M&A that did happen over the year was motivated not so much by expansionist desires but by consolidation in order to “prune the tree” and do things like get back office costs under control.
The main consequence of the downturn has been an enhanced respect for capital. We are seeing many more companies looking hard but ultimately walking away. With capital availability limited, managers are much more conscious of the value of what they have. They are determined above all not to make big mistakes and they are much more hesitant to commit.

The key element here is good information; buyers are being doubly careful about key metrics, particularly around working capital. They want to be sure that things like cash-flow, the internal rate of return and margins are what they say they are on the box. They are not so easily seduced by the notion that “bigger is better”. The result will be a strong capital agenda. Capital availability will be at the heart of all strategic decisions in the boardroom.

One of the features of the new scene that could become a serious management issue will be the level of conflict between CEOs and boards, with CEOs of cash-flush companies seeking to take advantage of the downturn to expand, and boards being more concerned about conserving capital. The scene is set here for potential conflict.

For mining companies, the capital management problem is becoming particularly acute. Many mining companies are involved in huge capex programmes. For mining companies, now it's all about conserving and optimising capital. Significantly, mining companies face competition for capital from government – something that has barely existed for almost a decade.

Interestingly, two key aspects of the M&A scene in South Africa may be headed in different directions: Private equity, which normally focuses more on delisting and leveraging companies, seems likely to return to the fray, but this time more weighted towards re-listing companies in their portfolios.

Exiting investments for private equity might become more prevalent in the near future, for precisely the same capital management reasons as are apparent in the rest of the industry.

On the other hand, Broad-based Black Economic Empowerment (B-bBEE) will continue to be a major feature of M&A, perhaps the one aspect of the M&A that has remained fairly consistent through the downturn.

B-bBEE activity has represented about 20% of all South African M&A activity over the past five years and that remained true in 2009. Some of the largest deals done in 2009 were BEE deals, notably SABMiller's black empowerment deal in its South African subsidiary, South African Breweries; and a Tiger Brands BEE transaction.

Yet the character of B-bBEE is changing too. The interesting thing about BEE in 2009 was that it included not only the new deals being consummated but deals coming to the end of their natural life. A good example is Mvelaphanda Resources finalising its BEE gold mining interests in Gold Fields, while Mvelaphanda Holdings was involved in the finalisation of the Batho Bonke consortium's relationship with Absa.

Another feature of M&A for South African companies going forward will be increasing activity on the rest of the continent of Africa. The character of transactions in the developed world and the developing world will also show marked differences.

From the acquirers' point of view, M&A in circumstances in which top-line growth is likely and possible is so completely different from M&A in circumstances where top-line growth is unlikely. In developed markets, the chance, in many industries, of top-line growth are pretty slim, so cost control is often a vital part of M&A. Things like swapping assets with your competitor to manage transport costs and rationalise your geographical spread suddenly become very logical.

In a developing world context, on the other hand, the game is very different; it's about outrunning your competitors, and while cost containment is clearly still crucially important, maintaining your competitive position is equally critical. Yet, overall, the prospects for M&A are looking up, although the return to normality could be “slow and hard-fought”. Several big international deals have already been concluded this year, and more are obviously in the pipeline.

Acquisitions are such enormous and risky decisions for acquirers, it's not surprising they are generally cautious. But there are a host of excellent reasons to consider M&A beyond the obvious that managers should consider. Brand expansion is one often overlooked example. Managers ought to be thinking about what could become the next Tastic rice, which can take a company into new markets and keep the brand portfolio current and modern. In a way, it is the same as mining companies buying exploration assets.

This past year, there was very much a batten down the hatches' and ‘live through the storm' kind of approach. It's now time to start looking forward. During the downturn, there was nowhere to hide, so that, if companies had three great divisions and one so-so division, the so-so division suddenly became a real problem. Managers were perhaps not as tightly focused on the things on which they should have been focused, and now they have been brutally exposed to what was not working. The time has come to deal with these newly visible problem areas.

Ernst & Young's inaugural Capital Confidence Barometer, an international survey conducted in 2009, found that the outlook for M&A is improving, but sellers remain cautious.

The survey found that the Barometer confirmed local commentary reflected in the survey, and showed that, internationally, companies were expecting a prolonged period of difficulty in securing financing with intense competition for capital for at least the next 12 months. This will be a slow and hard-fought recovery with shocks along the way. Economic uncertainty, increased risk, capital scarcity and investor caution all threaten to impede strategy implementation and impact shareholder return.

Sifiso Shongwe, BSc (Financial Management), is Infrastructure Advisory, Ernst & Young and his key areas of expertise include financial modelling, valuation analysis, deal structuring and debt raising, and Adrian McCartney CA(SA), is sector leader for Mining & Metals and head of Transaction Advisory for Africa, Ernst & Young.

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